Commentary
How Congress left the muni market guessing — again

Three weeks is a relatively long period to discuss the Deferred Action for Childhood Arrivals program and other immigration matters. However, this Congress has proven on many instances that talks may get stalled at critical times. At least with this week’s continuing resolution to keep the government open we have a six-year extension of the Children’s Health Insurance Program, resolving some of the uncertainty surrounding care of deserving children for now. But we cannot rest easy.

John Hallacy
Doug Goodman

There are many variables embedded in the federal budget that affect state and local budgets. The market has taken the news in stride, even with the increase in the 10-year Treasury yield. Yes, it is true that the Treasury market rallied in the wake of other shutdowns. There was even a rally after the U.S.A.’s rating was lowered by one of the major rating agencies in 2011.

However, we should not base our view of what may transpire in the future based on market lore. And there is still the pending matter of the Debt Ceiling. The run up to other debt ceiling expirations in many respects has been more nerve-wracking than a shutdown of the federal government. The timeline now is the expectation that the Treasury would run its course of extraordinary measures staving off an increase in the debt ceiling to sometime in March.

It has been my experience in the markets that when the cash flow wanes, the prospect for a developing crisis increases considerably. Of course, knowing what the true cash position is at any given point in time is also critical. A good proportion of our Treasury bonds are held abroad. We do not need set up a test case for payment of the federal debt. We need to use all of the available tools to instill confidence in the debt of the U.S.A.

The CR expiration is not much ahead of when the debt ceiling consideration will be a factor again. Any more delays could put the two elements too close together for comfort.

Given the backdrop of developments at the federal level, the states and in turn the localities are in the process of formulating their budgets for the new fiscal year. For the majority of states, the new fiscal year starts July 1. New York is always further along in the process because the fiscal year starts April 1. Assumptions must be adopted for changes in key revenue sources. This coming year is particularly challenging for the revenue forecasters given the enactment of the Tax Reform.

The income tax collection at the state level will be greatly influenced by anticipated taxpayer behavior. Ironically, the unearned income portion of the total income tax receipts may be somewhat easier to model given the positive performance in the markets. This year is also complicated due to the SALT consideration. California and New York have both entertained elaborate strategies to cope with the challenges ahead. These proposals probably just need a bit more time for vetting before final versions are adopted in full.

Trends in federal spending for appropriations to the states have particular importance in Medicaid, Education, and many other programmatic areas. Running on a continuation budget is relatively straightforward because the spending levels from the prior year are generally just continued. The practice does not necessarily prepare staffers for shocks ahead. There has been a lot of talk about holding domestic spending flat to down marginally while Defense spending is being targeted for measurable increases. Of course, deliberations lie ahead and there will be a great deal of debate before the numbers are finalized.

Resolving the federal budget for the two years may alleviate some of the pressure. But it needs to get done. We are already just about four months into the federal fiscal year. The states need to have a relatively clear picture of where they will need to compensate for cutbacks or as is the practice in many states, the cuts will just be passed through to the citizenry.

The uncertainties that the states and localities are facing at this time are not really being reflected in municipal spreads and levels. Given the lack of municipal supply and the technical aspect of the “January Effect” that is particularly strong this year, we have even tighter conditions in some respects. At the same time, rates in general are moving higher. In fairness, the tax-backed part of the market tends to move more when mid-year financial results are available and at the times of budget introduction and budget adoption, holding other factors constant. We see no reason why these market flashpoints should not adhere to the pattern this year, despite all of the noise from other inputs.

Another overriding factor is that the economy is strong and unemployment is at record lows. It is easier to forecast reliable budget numbers for the revenue side in a rising economy than in a declining one.

In this environment, we would anticipate a greater level of volatility as we progress further into the year. The Fed is poised to move on rates in March, but they may need some more time for deliberations if either the federal budget status or the debt ceiling becomes more of a consideration.

One of the wild cards is that the equity markets appear to have no rationale for departing their recent positive trends in the near term. There is also the real possibility that retail assets depart from municipals for the other markets that would affect the bid side.

Fortunately, the flows to the mutual funds continue to be positive despite the lack of supply and the low yields. Institutions are staying relatively long. We have not seen any attenuation in the appetite for long municipal paper.

We would really not prefer to see the federal level become more like Illinois and Pennsylvania with late budgets. If programs are going to be trimmed or their growth slowed, the states need to know sooner rather than later. IF DACA and other critical programs are not continued, backfilling by the states who choose to do so would be prohibitively expensive at a time when there is more uncertainty on the revenue side due to all of the recent changes.

The irony is that the municipal market continues to thrive in the face of all of these uncertainties. We just hope it will continue to do so. There are no markers out there that suggest otherwise. Contrarians have a growth opportunity.